Massive Upside Still Evident in MSB Price Once Capital Overhang...

Massive Upside Still Evident in MSB Price Once Capital Overhang Removed

I’ve noted here that when the current Mexican stand-off in the MSB price ends, and the Capital overhang is removed, I expect a quick spike higher in the price.

I looked at the short positions and concluded that the potential Capital selling may be the shorts’ last big chance to buy stock at these prices. I demonstrated why it is unlikely there will be any more big capital raisings, and therefore no opportunity to cover shorts in any volume. I expect the share price to pop back over $A2 once Capital’s overhang is removed.

However, I think the shorts will see heavy competition from the instos who were scaled back in the recent $A2 placement of 37.5m shares. Once they are confident that Capital’s overhang has been removed and that the share price will therefore bounce, they are likely to want to top up at a discount to the $2 they have already paid. I’m not sure that Capital is really a seller, but the market thinks they are, and that’s what is sitting on the MSB share price in the short-term.

I have also had a look at some of the valuation upside from using a US pharma WACC to discount MSB’s cash flows and show how much upside there is for a US pharma if it bids for MSB - the cash flows at the lower US WACC would get an uplift of at least 2x and probably more than 3x the current NPV of MSB (ie 3x the current $4.94 valuation by Bell Potter) if those cash flows were owned by a low WACC US pharma.

Alternatively, I considered the impact of the probability discounts on the MSB NPV, and still get to a figure over $A12 per share.

Finally, I looked at the cost to several pharmas of doing partnering deals with cumulative milestones of up to $US1 billion per indication in each major geographical region for the Heart and Back Pain products and again, get over $A12 per share of value if the pharmas just buy MSB (before counting any of the royalties).

I concluded that this potential valuation uplift makes MSB a juicy target for a US pharma on a low WACC. It is therefore important that MSB doesn’t make itself an easy takeover target by placing large amounts of equity to a potential partner, and that The Prof and key major shareholders maintain their percentage control and don’t accept any takeovers until full benefits can be seen at much higher prices.

I also looked at the current balance sheet cash and forecast cash burn and concluded that there is cash for at least 2 years, and probably more than 3 years including US aGvHD sales. Any more big partnering deals with big upfront payments would just load lazy cash onto the balance sheet and make MSB an even juicier takeover target – I think it is important to consider a buyback if such a deal is forthcoming, and that the buyback should be announced with the partnering deal to make the company look like it is considering efficient capital allocation. Of course, this would be a major pain for the shorts, as the price would spike higher on such an announcement.

Here’s a big more detail:


Short-term Mexican Stand-off in the MSB Share Price

The volume of trading in MSB has dropped off again as canny buyers sit back and wait for Capital to sell the remainder of their holding. Whether or not Capital are sellers, there’s a buyers’ strike as they see no need to buy until most of Capital’s perceived overhang is removed. Of course, it could all be done in one line, and I’m sure the local brokers have buyers lined up (especially those who took stock at $A2.00 recently) – however, the price is below where Capital recently sold 2m shares and they are probably waiting for a bounce, and the buyers may be sitting back, hoping to get in at a discount.

Either way, volumes have dropped right off again after the flurry of activity post the Grünenthal deal and the recent capital raising. I think that’s the lull before the storm. If an insto bids Capital for stock, they are hardly going to go into the market to buy the scraps on offer and probably push the price up in the process – that’s just bidding against yourself. Similarly, Capital are hardly likely to sell in the market at the moment – that would just push the price down and make it harder for them to get the price they want.

A miserable 6,537 ADRs traded on Friday night in the Nasdaq market – that was the sixth lowest day’s volume in the past year and compares with the daily average of 51,000 over the past year. Similarly, the volume in the Australian market on Friday was only 385,000 Thursday was only 551,000 and Thursday was 358,000 – Wednesday and Friday were both in the lowest 50 volume days of the past year, and compare with the daily average of 1.1 million shares traded.

The lower volume of the past 3 days shows the volumes retreating back to the lows of the past year. The following graph shows 3 day average trading volumes. Note that the highs coincide with the big positive and negative announcements (such as the infamous release of the LVAD trial results on 12 Nov 2018 – which coincides with a 3 day trading average of 5m shares per day). You can also see the big bump in trading volumes after the Grünenthal announcement (on 10 Sep 2019) and the recent capital raising on 3 October 2019:



Shorters have been covering and have taken advantage of higher daily volumes post the insto placement of 37.5m shares on 3 Oct. Shorts covered 4.4m shares in the week of Oct 3 to Oct 10. That was half of the stock traded that week of 8.9m. Up until the last 3 days, the daily volume was averaging nearly 1.7m per day, or around 600,000 more than the average daily volume for the past year. It is likely that the shorts took advantage of higher volumes and covered on the days that Capital was selling. This would have allowed the shorts to get some decent volume without having to push the price higher.

Lower volumes in the past 3 days are likely caused by Capital no longer selling and shorts no longer covering (as the lower volumes mean they would have to pay up to get stock) – however there is no sign of shorts increasing their position again. MSB is no longer one of the most shorted stocks in the market and shorts may well be hoping to get in on the action of bidding Capital for its remaining shares to further cover their position (and would be hoping for a discount).


Capital appear to be likely sellers of their remaining holding of 27.56m shares (5.14% of the company) after selling 3.2m at $A1.87 in their last substantial shareholder notice covering the period up until 21 October.

Of course, Capital may decide to hold on to the balance, especially if The Prof manages to convince the new manager of the Capital fund that this is one of the fund’s top 3 picks (as Mark Denning seems to imply with MSB one of 3 stocks held both in his Capital funds and also his trust – blind or not). I doubt they’ll hold however – usually once a new manager starts to sell, he keeps going.

This potential selling is capping the share price at present – with buyers standing back waiting for the Capital line to come out and Capital probably hoping for a price closer to the $A1.87 where they recently sold, rather than the current market price.

As @ddwn says," As the CR was taken up quickly at $2, why wouldn't you be happy to buy more if it at 10% less?".

Of course you would, particularly as there were cutbacks in the 37.5m shares issued at $2 and we know M&G were prepared to take nearly double the amount they were allocated in the placement, as per their previous letter to MSB which offered to buy $US15m of shares.

So, let’s assume there’s buying interest and selling interest. 27m shares isn’t a big bite if a broker can get a group of buyers together especially since they know who is interested after the recent placement (and the prime brokers would know who the major shorts are). So the usual suspects would be UBS, Bell Potter, Aitken Murray, possibly CSFB and maybe Morgan Stanley. The Capital selling looks like it was going through the pipes at UBS, and UBS has previously been active when shorts were active. Bell Potter and Aitken Murray were the brokers to the recent placement and CSFB has placed big lines of MSB in the past (eg Teva), though it hasn’t done much in the past year.

The real problem may be that Capital aren’t selling because they know the big guys recently paid $2 for reasonable volume, and they know the share price will bounce after their line is cleared. So if they sell now at below $A1.80 they may end up looking like boneheads (move over Teva!).

The same thing happened on March 14^th this year when Capital put through their S3 XT crossing at $A1.15 and then there was a huge bounce in the price ($A1.50 within three days). They would also want to avoid adding to the Mark Denning fiasco.

The reason the buyers aren’t buying is that they would be trying to bid Capital at the lowest possible price - probably a discount to whatever the price is on the day they bid (why not?). They probably think that Capital is more desperate to sell than they are to buy -hence the Mexican stand-off.

The only people benefitting at present are the shorts who have covered much more easily than would’ve been possible without the Capital selling. This has been a gift for them, but they have a fair way to go.



Shorts likely covering ahead of Capital clearing their line and a price bounce

On 25 October, there was big volume of 2.335m MSB shares traded including a bullish 95,000 traded on open at $1.79 up 2c on the previous day's close; with 600,000 shares traded up until 10:30am up to a feverish high of $1.885; then we saw two Block Special Crossings (S3 XT) for 600,000 shares both at $1.80 (1:151am for 320,000 and 1:49pm for 282,000); then a nice close at $1.82, up 2.8% on a big volume day.

Those S3 XT trades are evidence of insto buying (or big short covering – note that shorts covered 844,000 of their net position that day) - the same thing happened back in mid-March when Capital were selling and shorts covered 3.5m shares in one transaction. 25 October was smaller, but we know Capital has been selling recently and now we have people stepping up to cross stock. Previously Capital appear to have been putting their shares "down the pipes" through UBS's direct market access - but now it looks like they have been bid for a couple of lines. It may have been someone other than Capital selling, but I think they’re the best guess.

A reasonable guess is that these two lines were some shorts covering - getting in front of a possible placement to long holders who have the capacity to clear Capital's whole line. If the shorts don't cover now, they run the risk of being cut out if a small number of big instos bite at the big line. Having said that, I don't know who bought, and it could just as easily be some of the instos who took placement stock at $2 and who have waited for the price pullback to be over and who were averaging down.

Either way, the shorts are going to have to be quick if they want to take advantage of more selling by Capital, and the price is likely to bounce strongly once the Capital line is finally cleared.

Capital's selling in Feb/March this year put a lid on the price until the big crossing at $1.15 went through on March 14. Previous to that, the share price had been dumped down from $1.40 to around $1.15 and the short position rose to its high of 8.35% or 41.6m shares. After the March 14 block special crossing, the short position fell by 3.4m shares and the price shot up to $1.50 within 3 days. All up, Capital sold about 12m shares in that period. The shorts fell to 31m by April 1st, and have continued to fall to 26.6m by Oct 1st and 21.8m at the latest count.

That fairly steady fall in the shorts tells me that shorters have not been punting a big price fall from Capital this time - probably because the price fell quickly post the recent capital raising (around the same time the Mark Denning situation was escalating) and also because the MSB cash position is demonstrably secure for at least 2 years - so no further opportunity from here to cover shorts in a discounted capital raising.

The current bout of selling wasn't as well telegraphed as at the start of this year, and the shorts haven't been nearly as active, and that could mean that Capital don't intend to sell much more. However, we have to be cautious and work on the assumption that they are now below 27m shares and that the rest of their share holding will be sold.

It doesn't appear that any broker currently has the whole line to sell (or it would’ve been done by now), but that the two trades on 25 October were possibly Capital responding to someone testing the waters and buying a couple of lines. There's no guarantee of course that Capital was the seller, but the market is assuming that it was them.

If it was Capital selling, they've given the indication that they'll accept $A1.80 - and I'd expect Aussie brokers will be working hard to put together a buying consortium to try to take out the whole line soon (if they haven’t done that already). Even at a low rate of 10bp, that's still $100,000 of brokerage to put both sides of the deal together – worth fighting for!

As I've said before, instos who took the placement at $2 recently will have been waiting to make sure the price has bottomed out before taking Capital's line - averaging down in a stock you like looks like strong management if the price then bounces and you look pretty silly if you don't take it up around $1.80 after paying $2 – especially if it bounces and you have more to buy. Capital’s selling post placement appears aggressive and hasn't been handled through a broker trying to put together a big line of stock, but rather appears to have been spat out down the pipes.

So, one or two buyers seem to have bitten the bullet on October 25, broken ranks, and bid Capital for around 600,000 shares in total. That is combined with BIG volume of 2.3m shares on a day with no announcement and aggressive early buying, followed up by another couple of strong volume days on Monday and Tuesday last week, and then…nothing - my spider sense is tingling! Those buyers may have just been establishing a price where Capital is prepared to get out, and they may come back harder next week, or the rest of the market may pile in at that price. The lack of volume from Wednesday last week tells me something is happening – ie people are staying out of the market until it is completed. The low volume in the US on Friday night just compounds this.

This may well be the last chance to get set in a big line at a discounted price (remember it was $2.23 prior to the placement).

I know others have said in the past that “this is the last chance to get in at this price” - and there's always been another chance - but this time I think there's good reason to expect a strong bounce after Capital's line of stock is cleared (like happened in February this year).



Buyback potential – cash burn – balance sheet - reason for shorts to cover

After the Grünenthal deal and recent placement, MSB may never need another capital raising - unless a big new partner insists on having a placement to secure a position in the company (like when Cephalon took nearly 20%). IF that were to happen, MSB would have to consider a share buyback as the balance sheet would be groaning with unneeded cash.

Let's say a 20% placement at a premium price of $A2.50 would raise $A270m and issue 108m shares - a buyback over 6 months would need to buy 850,000 shares per day. On top of that, an upfront payment in a big US partnering deal of $US100m would also be totally surplus to cash needs and would be soaked up by a buyback of another 60m to 80m shares (depending if the share price is $A2.50 or closer to the current price of $A1.80). So just one big US partnering deal, with a 20% placement could result in 6 months of buyback of 1.5m shares per day for 6 months. I don't think the volume would exist in the market to do this, so they would probably have to go to rolling 6 month buybacks - especially if there are up to 3 big buybacks coming in the US and Europe.

The $US15.5m cash burn was lower than expected in the last quarter, with a $1.5m government grant received and the $US1.74m royalty received from JCR continuing to grow. The forecast cash burn from ordinary operations next quarter is $US21.92m, from which I deduct the JCR payment of $US1.9m to get an ongoing cash burn of $US20m per quarter. Of course the reported number will be much better than that, as the $US50.5m from the placement and $US15m from Grünenthal will be received in early October – so the actual cash position should be $US45.5m higher by the end of December.

However, it is the ongoing cash burn that interests me, and it appears that MSB can keep this to about $US20m per quarter. That should be compared with the proforma cash at the end of September of $US100m (including $US50.5m from the placement and $US15m from Grünenthal) plus another $US65m to be received over the next 12 months ($US30m from Grünenthal and $35m from existing lenders Hercules and NovaQuest).

So, cash and cash to be received is $US165m from end September, and that should last over 2 years, until October 2022. And that’s before any more partnering deals, or milestone payments from Tasly in China etc. It also doesn’t include any sales for paediatric aGvHD in the US market – which could start in July next year (as long as the BLA lodgement is completed pre Christmas as The Prof recently indicated, and the FDA stays within its 6 month fast-track approval guideline). The paediatric aGvHD market is expected to be worth $US120m (gross profit margin 60%, rising to 80% with the new manufacturing improvements), so could be earning a gross profit of $US50m pa (ie $100m for 2 years of sales by October 2022 – so that’s another 5 quarters of cash and takes the cash out to December 2023) assuming only a 50% market share. After that paediatric aGvHD, could rising to a gross profit in the US of $US100m pa over time PLUS off-label use (in 20 indications) which could start quickly after FDA approval (depending on doctors recommendations – ie MSB not allowed to sell off label, but doctors can request it) PLUS eventual label extension to adult aGvHD and chronic GvHD. PLUS Chronic Lower Back Pain royalties in Europe could well be starting by 2023 (assuming a 24 month trial starting in Europe next year and approval by the end of 2022 – and it could be 12 months faster than this if the Europeans just go for a 12 months confirmatory study). Depending on take up of patients in Europe, there could be further significant milestones received from Grünenthal (up to $US 1 billion in total) plus royalties.



Valuation upside and takeover considerations

@otherperspective has previously noted the harsh 21% Weighted Average Cost of Capital being used to discount MSB’s cash flows. For a growth company like MSB with negative cash flows in the short term and big positive cash flows out in the future, this discounting is particularly debilitating and makes MSB vulnerable to a takeover bid by a big pharma operating on a much lower WACC and discount rate.

On top of the valuation uplift that a big pharma would get if it were to buy MSB, it would get access to the prospectively large cash balance on the balance sheet, helping to pay for the bid. Any more big partnering agreements would just add to that cash hoard, and the partner could potentially also ask for a placement to lock in some influence (Cephalon took a nearly 20% placement when it did the deal back in 2010).

Many of us value MSB at multiples of the current share price, and would not welcome an opportunistic bid – yet as we get closer to FDA approval and first product sales, the share price is lagging well behind those valuations and it is possible that a bid of $A3 to $A4 would succeed.

It is important that the major supportive shareholders keep control (which they still have at present) and that the company doesn’t open the door to an opportunistic bid by making it easy to get stock at current low values.

As if the very high discount rate wasn’t bad enough, analysts are applying a “probability discount” to the cash flows. I believe this is a contravention of the consistency principle in finance theory – ie if you use high discount rates to reflect risk of cash flows, you shouldn’t double that discount up by applying a probability discount on top of that. Instead, if you want to probability adjust cash flows to indicate high risk, then you should use the certainty-equivalent approach, incorporating risk into the analysis by adjusting the cash flows rather than the discount rate – but you shouldn’t do both.

I can understand why analysts look to reduce their valuations of MSB – otherwise the number they get looks ridiculously high. For instance Bell Potter still gets a valuation of $A4.94 per share by using a 21% WACC and high probability discount rates. They only use a 44% probability of success for Chronic Lower Back Pain – ie less than 50% means it isn’t likely to succeed – yet MSB have already done a partnering deal with Grünenthal and are already receiving upfront payments.

Even if you want to argue that a 21% discount rate is appropriate for a risky company, have a look at the benefit for a big US pharma making a takeover bid – the comparable Weighted Average Costs of Capital are between 2.3% and 9% (see table below).



The MSB cash flows are forecast to be negative for the next 2 years, when the discounting is least (ie the valuation wears the biggest hit) and 50% of the valuation doesn’t even start to make sales until 2024. 4 years of discounting at 21% pa means a $1m cash flow in 2024 is only worth $466,000 to MSB’s NPV today – and that’s when those cash flows are only just starting, before several years of ramping up.

Let’s look at the opportunity for a big pharma with a lower WACC – they could buy MSB on say a 5% WACC (the average of the 10 companies in the table). A $1m cash flow received by a big pharma in 5 years would be discounted to $783,500 on a 5% discount rate (vs $385,500 for MSB on a 21% WACC)- that is, the valuation upside for the big pharma is that the NPV today of a cash flow in 5 years is worth double the value ascribed to MSB.

The equivalent figures for cash flows in 8 years (when the first products should be approaching market share maturity) show that the NPV of a $1 million cash flow for the big pharma is valued at $676,800 while for MSB it is only worth $217,600 – so the value for the big pharma is over 3x the NPV of the same cash flow for MSB.

Obviously, with half of MSB’s cash flows not starting until 4 years from now, and with growth past that point, a big pharma will benefit from the lower WACC and the cash flows will be worth at least 2x analyst valuations for MSB – for cash received in 8 years or longer, the big pharma’s NPV is 3x or more that of MSB. That is the valuation uplift a big pharma gets from making a takeover bid for MSB – it’s effectively free money.

So, if MSB is currently valued at $A4.94 per share, this could be worth at least $A10, and probably more like $A15 to a big pharma, especially considering the “probability of success” discounts (60% likelihood of success for CHF, only 44% likelihood for CLBP, 40% for End-stage CHF with LVAD, a skimpy 14.5% probability for Diabetic Necropathy and 20% for Rheumatoid Arthritis).

In other words, if these potential products go ahead, you can multiply the NPV by 6.9x for Diabetic Necropathy, by 5x for Rheumatoid Arthritis, by 2.5x for End Stage CHF with LVAD, by 2.3x for CLBP, and by 1.67x for CHF. On the basis of 100% probabilities for all of these products, the valuation would rise from $US3.58 to $US8.39 per Australian share or $A12.13 – and that’s still at a WACC of 21%! Remember, that WACC already takes risk into account.

The potential valuation uplift for a big US pharma is enormous. Of course, there is risk involved, but MSB has already finished one phase 3 trial for paediatric aGvHD, has nearly completely submitted the BLA and will finish the phase 3 trials in its much bigger indications of heart and chronic lower back pain in the first half of 2020.

A takeover by a big pharma would gain all these products worldwide. The alternative is a lower risk approach of an upfront and milestones plus licensing deal. That will potentially cost Grünenthal up to $US1 billion in cumulative milestones plus royalties if it gains maximum success in Europe and LatAm. Of course, if it doesn’t work, or doesn’t sell, Grünenthal would save a lot of money.

Let’s consider the potential upside of partnering Heart and Back Pain in Europe, US and China – each of those could be worth the same $US1 billion in cumulative royalties that Grunenthal has just signed up for. That’s potentially long term cumulative milestones of $US5 billion to $US6 billion plus royalties. That’s $A13.45 to $A16.14 per share. Even if it takes 5 years to earn those milestones and you discount the $A16.14 at a US pharma’s WACC of 5%, you still get $US12.65.

It doesn’t include anything for Rheumatoid Arthritis or Diabetic Necropathy, which are the next indications on the production line.

It doesn’t include anything for Japan – and given that the Japanese are clearly pushing ahead on stem cells, you’d have to think a major partnering deal on heart or back pain is possible there. I noted a few months ago that if Sumitomo really wanted to get into stem cells it would make more sense to partner with MSB through a licensing agreement, which would allow them to get into production years quicker than going with CYP which has so far only completed phase 1 trials (and that CYP’s cells would probably infringe MSB’s patents, meaning that Sumitomo could well end up having to pay MSB a royalty even if they did go with CYP).

Bottom Line

The share price could be set for a quick bounce once the perceived Capital overhang is out of the way - either Capital sells to the instos who took the recent placement, or the shorts use it as their last opportunity to cover shorts at prices below $2, or Capital makes a declaration they aren't sellers. These sorts of situations never last long, as profits tend to force a solution.

The recent 4C announcement reiterated that MSB is in "active negotiations regarding potential commercial transactions and access to non-dilutive capital" - and as the Grunenthal announcement came as a bolt from the blue, so too could the next partnering agreement. As noted above, I wouldn't be surprised to see an agreement with Sumitomo after they spent months looking at CYP as a potential takeover target. I'm sure Sumitomo's due diligence would've noted the partnering/licensing agreements between MSB and JCR and Takeda. Sumitomo seems to be motivated to do more in the stem cell space and MSB would seem to be a logical partner.

As the recent 4C noted, MSB "is in active negotiations regarding potential commercial transactions and access to non-dilutive capital" - a deal could literally come at any time (as with Grunenthal) and as I've noted, a big upfront payment should be neutralised with a buyback. A buyback would help the Prof and supportive instos to rebuild their % holding in the company and ensure the share register rebuffs a low ball bid (having regard to the valuation numbers I included in this note showing that MSB's cash flows could be worth at least 2x and probably more than 3x the current NPV $A5 share price valuation to a low WACC US pharma company).

So there are short term and long term reasons the MSB share price should rise, starting with a resolution of the Capital overhang, probably before the end of this month.